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An Overview of Capital Management for Property/Casualty Insurers

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An Overview of Capital Management for Property/Casualty Insurers Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D. Actuarial Science Program University of Illinois at Urbana ... – PowerPoint PPT presentation

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Title: An Overview of Capital Management for Property/Casualty Insurers


1
An Overview of Capital Management for
Property/Casualty Insurers
  • Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.
  • Actuarial Science Program
  • University of Illinois at Urbana-Champaign
  • Casualty Actuarial Society
  • Washington, DC
  • July, 2003

2
Agenda
  • Capital management and its inclusiveness
  • Putting capital management in a financial
    services industry context a look at the banking
    world
  • The financial theory underlying capital
    management
  • Discussion of cost of capital
  • Capital management for property / casualty
    insurance

3
Capital Management and its Inclusiveness
4
What is Meant by Capital and Capital
Management
  • Capital (and surplus)
  • Assets less liabilities
  • Owners equity
  • Support for (riskiness of) operations
  • Thus, supports profitability and solvency of firm
  • Capital Management
  • Determine need for and adequacy of capital
  • Plans for increasing or releasing capital
  • Strategy for efficient use of capital

5
Types and Measures of Capital
  • Statutory
  • Inherently conservative solvency perspective
  • GAAP
  • Going concern income statement orientation
  • Risk-based capital
  • Required capital based on risk attributes and
    promulgated charges
  • Economic
  • Required capital in order to achieve a specified
    solvency standard

Actual
Theoretical
6
Why Do We Care About Managing Capital?
  • Leads to solvency and profitability
  • Benefits of solidity and profitability
  • Higher company value
  • Happy claimholders (policyholders,
    stockholders,...)
  • Better ratings
  • Less unfavorable regulatory treatment
  • Ability to price products competitively
  • Customer loyalty
  • Potentially lower costs

7
The Problem With Capital
  • A certain amount of capital is needed in order to
    promote solvency
  • Thus, need to be able to raise capital
  • But.... If there is too much capital,
    profitability (as measured by return on equity)
    will suffer
  • Thus, need to be able to efficiently deploy
    capital

8
What Does Capital Management Entail?
Capital Structure
Financial Risk Mgt.
Raising Capital
Capital Management
Setting Objectives
Strategic Planning
Liability Valuation
Product Pricing
Asset Allocation
9
Putting Capital Management in a Financial
Services Industry Context A Look at the Banking
World
10
Banks How They Improved
  • After the near-death experience of the late
    1980s and early 1990s, banks began to invest
    where the rewards for investing were not just
    higher but also better in relation to the amount
    of risk they were takingin other words, they
    started looking at risk-adjusted returns. This
    meant that they began to jettison businesses that
    were insufficiently profitable.
  • What worries banks most, however, is not that
    their fees might drop, but that their main
    businesslending, which still accounts for most
    of their revenueswould come a cropper. That is
    where most of their capital is at risk. And that
    is why their favourite gripe is about the bankers
    at Basle.
  • - Renaissance Men, Economist, 4/15/99

11
From the Fed Bank Capital
  • BOARD OF GOVERNORS OF THE FEDERAL RESERVE
    SYSTEM DIVISION OF BANKING SUPERVISION AND
    REGULATION
  • SR 99-18 (SUP)
  • July 1, 1999
  • SUBJECTAssessing Capital Adequacy in Relation to
    Risk at Large Banking Organizations and Others
    with Complex Risk Profiles

12
From the Fed Bank Capital (cont.)
  • ....increasing emphasis on banking
    organizations' internal processes for assessing
    risks and for ensuring that capital, liquidity,
    and other financial resources are adequate in
    relation to the organizations' overall risk
    profiles.
  • ....one of the most challenging issues faced by
    bankers and supervisors is how to integrate the
    assessment of an institution's capital adequacy
    with a comprehensive view of the risks it faces. 
    Simple ratios - including risk-based capital
    ratios - and traditional rules of thumb no longer
    suffice in assessing the overall capital adequacy
    of many banking organizations, especially large
    institutions and others with complex risk
    profiles such as those significantly engaged in
    securitizations or other complex transfers of
    risk.
  • (continued)

13
From the Fed Bank Capital (cont.)
  • ....this letter directs supervisors and
    examiners to evaluate internal capital management
    processes to judge whether they meaningfully tie
    the identification, monitoring, and evaluation of
    risk to the determination of the institution's
    capital needs.
  • ....this letter describes the fundamental
    elements of a sound internal capital adequacy
    analysis - identifying and measuring all material
    risks, relating capital to the level of risk,
    stating explicit capital adequacy goals with
    respect to risk, and assessing conformity to the
    institution's stated objectives - as well as the
    key areas of risk to be encompassed by such
    analysis.
  • (continued)

14
From the Fed Bank Capital (cont.)
  • Current industry practice   Most institutions
    consider several factors in evaluating their
    overall capital adequacy a comparison of their
    own capital ratios with regulatory standards and
    with those of industry peers consideration of
    identified risk concentrations in credit and
    other activities their current and desired
    credit agency ratings, if applicable and their
    own historical experiences including severe
    adverse events in the institution's past.  Some
    more sophisticated banks also use risk modeling
    techniques and scenario analyses to evaluate
    risk, but generally have not yet incorporated
    such analyses formally into their overall
    assessment of capital adequacy.
  • (continued)

15
From the Fed Bank Capital (cont.)
  • Fundamental Elements of a Sound Internal Capital
    Adequacy Analysis
  • 1) Identifying and measuring all material risks
  • 2) Relating capital to the level of risk
  • 3) Stating explicit capital adequacy goals with
    respect to risk
  • 4) Assessing conformity to the institution's
    stated objectives
  • Composition of Capital
  • ....it has been the Board's long-standing view
    that common equity (that is, common stock and
    surplus and retained earnings) should be the
    dominant component of a banking organization's
    capital structure and that organizations should
    avoid undue reliance on noncommon equity capital
    elements.

16
Basle I
  • 1988 Basle Accord
  • By 1992, banks had to have a capital ratio of 8
  • Capital ratio amount of available capital /
    risk-weighted assets
  • Risk-weighted assets
  • Only explicitly identifies two types of risks
    (1) credit risk (2) market risk
  • Other risks presumed to be covered implicitly

17
Basle II
  • Ongoing have issued third Consultative Document
    (comments due by 7/31/03)
  • New Accord includes three pillars (1) minimum
    capital requirements (2) supervisory review of
    capital adequacy (3) public disclosure
  • Pillar 1 proposals to modify definition of
    risk-weighted assets
  • Changes to treatment of credit risk
  • Explicit treatment of operational risk

18
The Financial Theory Underlying Capital Management
19
Steps in the Financial Risk Management (FRM)
Process
  • Determine the corporations objectives
  • Identify the risk exposure (e.g., FX risk)
  • Quantify the exposure (e.g., measure volatility)
  • Assess the impact (DFA)
  • Examine financial risk management tools
  • Select appropriate risk management approach
  • Implement and monitor program

20
Finance Theory and Capital Management
  • Why bother to worry about financing or FRM (or
    any risk management), in light of the capital
    structure irrelevance proposition?
  • Modigliani-Miller (1958) if financing does
    matter, it must be because of one or more of
  • Tax effects convex tax function
  • Financial distress / bankruptcy costs
  • Effects on future investment decisions

21
Post-FRM
Pre-FRM
22
Derivatives Use Among Insurers
  • Activity during 1994
  • Cummins, Phillips, Smith (1997)
  • 142 P/C insurers (7) used derivatives in 1994
  • Larger companies more likely to use derivatives
    than smaller companies
  • Most often used contracts for P/C insurers
  • Foreign currency forwards
  • Equity options
  • Other (FX) activity in 1994 in
  • Foreign currency swaps
  • Foreign currency futures
  • Foreign currency options

23
Derivatives Use Among Insurers (cont.)
  • Anecdotal evidence from SEC 10-K filings
  • Specific mentions re FX risk include
  • Currency swaps
  • Foreign currency forwards
  • Asset-liability management
  • Sensitivity analysis with respect to hypothetical
    changes in exchange rates
  • Investments in foreign currencies
  • Cash flows from foreign operations, to fund
    investments in foreign currencies

24
Capital Structure - Theory
  • To finance ops., firm can issue debt or equity
  • Capital Structure firms mix of securities
  • Does this mix selection affect firm value?
  • Miller Modigliani said No (in perfect capital
    markets)
  • Firm value is determined by its real assets
    value is independent of capital structure
  • Capital structure irrelevant (for fixed
    investment decisions, no taxes, no costs of
    financial distress)
  • Allows separation of investment and financing
    decisions

25
Capital Structure - Reality
  • Modigliani-Miller Proposition capital structure
    decision is irrelevant to firm value, under
    certain friction-free assumptions (e.g., no
    taxes)
  • But in reality, there are taxes
  • There are also costs associated with financial
    distress

26
Interest Tax Shield
  • Tax-deductibility of interest may make some debt
    in the capital structure attractive
  • Discount the interest tax shield by the rate
    demanded by investors holding the debt
  • PV (tax shield) t (rd D) / rd t D
  • (assumes debt in perpetuity)
  • Value of firm increases by PV (tax shield)
  • Value of firm value if all equity-financed
  • PV (tax shield)

27
Costs of Financial Distress
  • However....
  • Increasing debt ? increasing risk and increasing
    likelihood of distress, which has costs
    associated with it e.g.,
  • Costs of shareholder bondholder conflicts
  • Costs of potential bankruptcy
  • Costs associated with inability to operate
    optimally / efficiently
  • Costs associated with bond provisions / compliance

28
Sample Debt / Equity Tradeoff Chart
Firm Value
PV(costs fin. distress)
PV(tax shield)
Debt / Equity Ratio
29
Other Capital Structure Issues
  • More on debtholdershareholder conflicts
  • Projects / investments more risky versus less
    risky
  • High versus low dividend payouts
  • Pack-it-in versus keep-hanging-on
  • Financing pecking order theory
  • Order of preference (1) internal financing
    (2) issue debt (3) issue equity
  • More profitable / cash flow ? dont need external
  • External can send adverse signals

30
Issuing Securities
  • Initial public offerings
  • Engage an underwriter(s)
  • File SEC registration statement
  • Prospectus (red herring)
  • General cash offers
  • Similar steps to those for IPO above
  • SEC Rule 415 shelf registration
  • Announcement of equity issue empirically, small
    decline in stock price
  • Signal to investors
  • Puzzle re long-run underperformance

31
Issuing Securities (cont.)
  • Private placements
  • Significant on debt side
  • Less costly flexible
  • Counterparty concerns less liquid
  • Costs of security issuance
  • Accounting and legal
  • Underwriting
  • Spread
  • Possibility of underpricing securities

32
Dividends
  • Declared by board of directors
  • Once declared, an obligation
  • Modigliani Miller dividend policy is
    irrelevant in a world without taxes, transaction
    costs, etc.

33
Types of Dividends
  • Regular cash divs. expect to maintain
  • Extra dividend may not be repeated
  • Special dividend unlikely to be repeated
  • Liquidating dividend
  • When going out of business
  • Distribution of assets (return of capital)
  • Stock dividend shares of company or subsidiary
  • For company conserves cash
  • For investor not taxed until sold

34
Limits on Dividends
  • By bondholders
  • Covenants prevent the distribution of the firms
    assets as dividends to stockholders
  • Company cant issue a liquidating dividend if
    funds are needed for protection of creditors
  • By state law
  • Prohibits paying dividend that would make the
    company insolvent
  • Prohibits paying dividends out of legal capital

35
Dividend Viewpoints
  • Tax effects ? low dividend preferable
  • Investor preferences ? high dividend payouts
  • Somewhere in-between are those who subscribe to
    the original MM proposition that dividend policy
    is irrelevant

36
Share Repurchase
  • Alternative to paying cash dividends
  • Often used when
  • Company has accumulated lots of cash
  • Wants to replace equity with debt
  • Methods of repurchase
  • Open market
  • General tender offer to all or small shareholders
  • Direct negotiations with major shareholder
  • Repurchased shares seldom de-registered and
    canceled

37
Liquidity Ratios
  • Indicators of riskiness, financial strength
  • Short-term cashability
  • More reliable values for liquid assets
  • Short-term ? can become out of date
  • Possibly seasonal
  • Ratios
  • Current ratio current assets / current
    liabilities
  • Quick ratio (cash marketable securities
  • receivables) / current liabilities
  • Cash ratio (cash marketable securities) /
  • current liabilities

38
Leverage Ratios
  • Measures of financial leverage (capital
    structure)
  • Ratios (other definitions are possible)
  • Leverage Ratio assets / equity
  • 1 (debt/equity)
  • Debt ratio long-term debt /
  • (long-term debt equity)
  • (Here, long-term debt includes value of leases)
  • Times interest earned EBIT / interest expense
  • (Numerator sometimes includes depreciation)

39
Market Value Ratios
  • Combine accounting (book) and stock (market) data
  • Ratios
  • Price-earnings ratio stock price / EPS
  • Earnings yield EPS / stock price 1 / (P/E)
  • Market-to-book ratio stock price /
  • book value per share
  • Dividend yield dividend per share / stock price
  • Tobins q MV of firm / replacement cost

40
Profitability Ratios
  • Measures of profitability and efficiency
  • Ratios
  • Sales to total assets (or asset turnover)
  • sales / average total assets
  • Profit margin EBIT / sales
  • Average collection period
  • (average receivables) / sales x 365
  • Also ROE, ROA, Payout Ratio
  • (Note Usually use averages for snapshot figures
    when comparing them with flows)

41
Other Ratios
  • Capital ratios
  • E.g., capital / liabilities capital / assets
    capital / weighted asset formula
  • NAIC IRIS ratios e.g.,
  • Premium / surplus
  • Change in premium writings
  • Surplus aid to surplus

42
International Differences
  • United States
  • Companies widely held
  • Rely largely on financial markets
  • Germany
  • Cross-holdings of companies layered ownership
  • Greater reliance on banking system
  • Japan
  • Kiretsu network of companies, usually
    organized around a major bank
  • Most financing from within the group

43
Debtholders vs. Shareholders Whos Interested in
What?
Probability
Shareholders
Debtholders
Firm Value
44
Option Values Payoff Charts
Payoff
  • Call -- long position
  • Call -- short position
  • Put -- long position
  • Put -- short position

ST
X
X
ST
ST
X
X
ST
45
Payoff and Profit/Loss Profiles Long a Call Option
Payoff
Profit/Loss
ST
Call Premium
X
46
Black-Scholes Option Pricing Model
  • Variables required
  • 1. Underlying stock price
  • 2. Exercise price
  • 3. Time to expiration
  • 4. Volatility of stock price
  • 5. Risk-free interest rate

47
Black-Scholes Formula
  • VC S N(d1) - X e-rt N(d2)
  • where
  • d1 ln(S/X)(r0.5s2)t / st0.5
  • d2 d1 - st0.5
  • where N( ) cumulative normal distribution,
  • S stock price,
  • X exercise price,
  • r continuously compounded risk-free interest
    rate,
  • t number of periods until exercise date, and
  • s std. dev. per period of continuously
  • compounded rate of return on the stock

48
Options Capital Structure
  • Both components of capital structure, equity and
    debt can be viewed within the option (contingent
    claim) framework
  • Thus, we can bring powerful valuation tools from
    option / contingent claim theory to bear on
    questions of capital structure, firm value,
    pricing of insurance policies, etc.

49
Options Capital Structure (cont.)
  • Equity residual claim on value of the firm
  • Contingent value after other claimholders
  • If firm defaults, equityholders put the company
    onto the debtholders
  • This reflects equityholders limited liability

Equity Payoff
Firm Asset Value
L
50
Options Capital Structure (cont.)
  • Debt claim on firm assets takes priority
    relative to equity
  • Value contingent upon firm asset value
  • Bondholders hold the assets and write a call to
    the equityholders

Debt Payoff
Firm Asset Value
L
51
Applying the Option Pricing Model to Insurance
  • Use option pricing to determine the value of each
    claim on an insurers assets
  • Policyholders Claim H
  • Governments Tax Claim T
  • Owners Claim V
  • Neil Doherty and James Garven, 1986, Price
    Regulation in Property-Liability Insurance A
    Contingent Claims Approach, Journal of Finance,
    December

52
Option Pricing Model Applied to Insurance
Stockholder Value
Taxes
0
Liabilities
Beg. Assets
Terminal Asset Value
53
Value of Various Claims at the End Of the Period
  • Policyholders claim
  • H1 MAXMINL,Y1,0
  • Governments tax claim
  • T1 MAXti(Y1-Y0)P-L,0
  • Owners claim
  • Ve Y1 - H1 - T1

54
where
  • S0 Initial equity
  • P Premiums (net of expenses)
  • Y0 Initial assets S0 P
  • R Investment rate
  • k Funds generating coefficient
  • Y1 Ending assets
  • S0 P (S0 kP)R
  • L Losses
  • t Tax rate
  • i Portion of investment income that is taxable

55
Determine The Value Of These Claims At The
Beginning Of The Period
  • V(Y1) Market value of asset portfolio
  • CAB Value of call option with exercise
    price of B on asset with value of A
  • E(L) Expected losses
  • H0 V(Y1) - CY0E(L)
  • T0 tCi(Y1 - Y0) P0E(L)
  • Ve V(Y1) - H0 - T0
  • CY0E(L) - tCi(Y1 - Y0) P0E(L)

56
Use Of Option Pricing To Set Insurance Premiums
  • To determine the fair premium, the premium
    level is determined for which the owners claim
    is equal to the initial equity. Thus, the owners
    receive a fair investment return.

57
Discussion of Cost of Capital
58
Cost of Capital
  • Weighted Average Cost of Capital (WACC)
    weighted average of firms (after-tax) financing
    source costs
  • WACC rs ws rp wp rd (1 t) wd
  • where r cost, w weight, t tax rate, s
  • common stock, p preferred stock, and
  • d debt

59
Cost of Capital
  • Cost of capital can be used as a hurdle rate
    against which to measure investment decisions.
  • Weights are the long-run proportions of the
    various financing sources comprising the firms
    capital structure
  • Key is to determine the costs, or rates,
    associated with each financing source
  • Can use CAPM, APT, etc.

60
Capital Asset Pricing Model
E(Ri) Rf ?i E(Rm) - Rf
where E expected value operator Ri
return on an asset Rf risk free rate Rm
return on market portfolio ?i Cov(Ri,Rm) /
?2(Rm) systematic risk
61
Arbitrage Pricing Model
  • The APM is similar to the CAPM with regard to
    classifying risk as either diversifiable or
    non-diversifiable.
  • The APM does not require investors to be
    concerned only with market risk.
  • The APM allows consideration of any number of
    factors to influence the risk of an investment.

62
Arbitrage Pricing Model (cont.)
Ri ai bijIj ei
R realized rate of return a intercept b sens
itivity of return to index I value of
index e error term i asset indicator j facto
r indicator
63
An Alternative Hurdle Rate Approach
  • CAPM ignores existing portfolio when
    contemplating price / capital needed to support
    one more risk
  • Add a factor to the CAPM
  • Reflects correlation of new risk with existing
    portfolio
  • Incremental capital to maintain existing target
    probability of ruin

Froot and Stein, A New Approach to Capital
Budgeting for Financial Institutions,
Journal of Applied Corporate Finance, Summer
1998. Also, Froot, A Fundamental Framework
for Managing Capital Risk, in Managing
Capital and Expectations Through Effective Risk
Management, Guy Carpenter
64
Capital Management for Property /
Casualty Insurance
65
The Insurers Capital Challenge
  • Four separate but related troubles are to blame.
    The first is falling premiums. The second is
    falling interest rates. The third is stagnant
    growth. And the fourth is excess capital. Too
    much capacity and too little demand feed on each
    other, reducing premiums further still.
  • The insurance industry is in trouble. The main
    reason is that it has too much capital.
    Shareholders should ask firms to give it back to
    them
  • The one thing that insurers do have some power
    over is the amount of capital in their business.
    Indeed, managing that capitalboth its amount and
    its costought to be the essence of an insurance
    managers job description.
  • - Capital Punishment, Economist, 1/16/99

66
Alternatives to Capital
  • Insurers are discovering what bankers know as
    securitisation the process of assembling
    mortgages, credit-card receivables or even
    business loans into securities that provide
    reasonably predictable income streams and
    principal repayments. This sort of financial
    engineering has been going on for decades in
    America.... Its big advantage is that, once the
    assets have been sold, the issuer need no longer
    set aside capital to cover potential losses
    instead, the capital can be redeployed more
    profitably. Insurers are only now waking up to
    the potential benefits.
  • - An Earthquake in Insurance, Economist,
    2/26/98

67
New Risks ? New Capital Needs
  • ....insurers have started bundling traditional
    and non-traditional risksexchange-rate, business
    interruption, fire, and so onand selling their
    clients protection against all of them with
    so-called multi-trigger policies.
  • Having thus widened their (insurers) definition
    of risk, they then teamed up with investment
    banks to devise new sources of capital to pledge
    against it. Traditionally, insurance capital was
    what was paid up by the shareholders of insurance
    companies. But in future it may include savings
    stored in banks, pension funds and mutual funds.
  • - The New Financiers, Economist, 9/2/99

68
An Opportunity for Actuaries
  • International banks, and their regulators, are
    wrangling over the level of additional capital
    that banks should be made to carry, as a cushion,
    against so-called operational risk that might
    damage a banks health or even the financial
    system. Operational risk includes anything from
    computer failure and postal strikes to fraud and
    cock-ups of Baring-style proportions. Insurance
    companies.... have joined the fray, offering to
    replace bank capital with new-fangled insurance
    cover.
  • Most insurers think a capital-markets solution
    for operational risk is a distant goal. The
    nearer one is to bring their centuries of
    actuarial skills to bear to help banks save
    capital, and so to tap a rich new market of,
    potentially, 30,000 banks.
  • - Capital Cushion Fight, Economist, 6/7/01

69
Problems for Insurers
  • The insurance industry is in poor shape,
    particularly in Europe.... ....the biggest
    reason to worry about their (European insurers)
    solvency is their over-investment in equities.
    Three years ago, on average they had 30-40 of
    their assets invested in equities, though some
    British insurers had as much as 80. This is in
    stark contrast to American insurers, which
    invest, on average, only about a fifth of their
    assets in shares.
  • Regulators in some countries impose a ceiling on
    equity investment. In Germany, for instance,
    there is a statutory limit of 35. In America,
    the controls are imposed via higher capital
    requirements for investing in equities.
  • (continued)

70
Problems for Insurers (cont.)
  • To strengthen their balance sheets, insurers and
    reinsurers have become increasingly creative at
    finding new ways to raise capital. Those most in
    need have turned to their shareholders with a
    rights issue.
  • Some PC insurers raised new capital in order to
    be able to take on new business, rather than out
    of any desperation for cash.
  • Shedding assets has been another way to raise
    cash and pay for the sins of the past.
  • - Poor Cover for a Rainy Day, Economist,
    3/6/03

71
Canadian Regulation
  • Dynamic Capital Adequacy Testing (DCAT)
  • (DCAT) is the process of analyzing and
    projecting the trends of a companys capital
    position given its current circumstances, its
    recent past, and its intended business plan under
    a variety of future scenarios. The DCAT process
    is to include the running of a base scenario and
    several adverse scenarios
  • -- Canadian Institute of Actuaries, Dynamic
  • Capital Adequacy Testing Life and
  • Property and Casualty

72
Canadian Regulation (cont.)
  • (One possible approach would consist of)
    stress-testing of the risk category in
    question Stress-testing means a determination
    of just how far the risk factor in question has
    to be changed in order to drive the companys
    surplus negative during the forecast period, and
    then evaluating if that degree of change is
    plausible or not. When stochastic models with
    reasonable predictability are available, an
    adverse scenario would be considered plausible if
    all remaining probability in the tail beyond this
    scenario is in the range of 1 to 5.
  • -- Ibid

73
Canadian Regulation (cont.)
  • the concept of capital adequacy envisioned by
    DCAT extends beyond the balance sheet at a
    specific date to the continued vitality of the
    organization The principal goal of this
    process is to help prevent insolvency by arming
    the company with the best information on the
    course of events that may lead to capital
    depletion, and the relative effectiveness of
    alternative corrective actions.
  • -- Canadian Institute of Actuaries, ibid.

74
Capital Management for Insurers Issues
  • Determine the economic (required) capital
  • Make adjustments to actual capital position, if
    necessary
  • Allocate capital
  • Measure performance relative to capital
  • Deploy capital most efficiently

75
Strategies for Managing Capital
  • If capital is inadequate (i.e., actual lt
    economic)
  • Raise new capital
  • Internal retained earnings realizing capital
    gains
  • External equity debt surplus notes
  • Reduce risk level of firm
  • Reduce exposures
  • Reinsurance
  • Strengthen underwriting standards
  • Reduce financial risks

76
Strategies for Managing Capital (cont.)
  • If there is excess capital (i.e., actual gt econ.)
  • Payout to shareholders
  • Increase dividends
  • Repurchase shares
  • Greater capital investment activity
  • New lines or areas of insurance
  • Acquisitions
  • Increase risk level of firm

77
Other Issues in Capital Mgt.
  • Controlling expenses
  • Uncovering hidden capital
  • Managing dividends
  • Managing reinsurance
  • Managing asset allocation, buying, and selling

78
Applying RAROC
  • RAROC Risk-adjusted return on capital
  • Emerged from the banking industry
  • Reflects expected return on economic capital
  • Applied to insurance
  • Aggregate (accounting for correlations) risk
    measures and economic capital across all risks
  • Reattribute economic capital back to sources of
    risk
  • Measure capital productivity and performance

Nakada, Shah, Koyuoglu, and Collignon, PC
RAROC A Catalyst for Improved Capital
Management in the Property and Casualty Insurance
Industry, Journal of Risk Finance, Fall 1998
79
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